The bond insurers have all rocketed today on the expectation that a bailout from the banks will be announced any time now. But this has hardly tempered the words of their critics. Everyone from Bill Ackman to Warren Buffett has criticized bond insurers for guaranteeing complex derivatives whose underlying risk they seem not to have understood. Even the core business of the insurers—guaranteeing municipal bonds—has come under fire.
In this month’s Portfolio, writer Jesse Eisinger argues that bond insurance is a racket, basically a tax-payer rip-off carried out by the collusion of bond insurers, Wall Street firms and credit rating agencies. It s a pretty extraordinary claim, for which Eisinger offers no real evidence other than the allegations of a Attorney General who hopes to be the next Eliot Spitzer and a claim that the ratings agencies consistently assign municipal bonds ratings that are too low.
Here’s how Eisinger thinks the racket works. Municipalities seeking to raise money issue bonds which are rated by credit rating agencies. The agencies give them ratings that are too low. Lower ratings means higher interest payment costs. To avoid these costs, the municipalities turn to bond insurance to bolster their ratings. The ratings agencies are all too happy to help out the bond insurers by delivering low ratings because the insurers are some of their best customers.
The argument hinges on the idea that municipal bonds are under-rated. Eisinger’s evidence for this is that according to Moody’s research, almost every municipal bond would get a higher rating is they were rated with the same criteria used to rate corporate bonds. “About two-thirds would probably be triple-A if they were rated with the same criteria used to rate corporate bonds,” he writes. “The obvious conclusion is that Moody's, as the most influential of the credit-rating agencies, should simply start lifting its ratings on municipalities.”
But, of course, that conclusion is far from obvious. We’d only want to require the same criteria for corporate bonds and muni bonds if we discovered that measuring them by different criteria created some serious market failure. But markets aren’t as stupid as that. Markets are very much aware that muni bonds rarely default, regardless of the rating. This is why muni bond investors accept lower yields—they know they are getting less risk. Similarly rated corporate and muni bonds are not similarly priced—the munis have lower yields that reflect their lower risk. The only way to conclude that the muni bonds are rated too low is to ignore pricing differences. (Yes, I'm aware that pricing differences are typically assigned to tax differentials but I think this analysis overstates tax benefits and understates risk differences.)
Imagine if this were not the case. If munis were consistently rated too low and the market somehow overlooked this error, there would be huge opportunities for risk-free return in the market. We would expect arbitrageurs to very quickly make these opportunities vanish. The bond markets are not a place where these types of errors persist for long.
The mistake in the analysis is to treat ratings as if they were some kind of Platonic ideas, unchanging and perfectible. In reality, they are hermeneutic devices that are well-understood by the market players who use them. They exist to reduce information costs and commodify products but do not tell us everything we need to know about investment assets. This is well known and reflected in the pricing of these assets. In fact, rating munis according to the same criteria as corporate bonds would reduce the amount of information available to the market by obscuring differences in the risks of different municipalities. If two-thirds of munis were rated triple-A, investors would lack guidance about real differences between the issuers.
The truth is that different types of debt are rated on different scales, and the market is very well aware of this. Muni are rated on a scale that compares them to other munis, not corporate bonds. Corporate bonds, in turn, were obviously rated on a different scale than CDOs, and the market reflected its awareness of this by requiring higher yields for highly rated CDOs than it did for highly rated corporate bonds. The scandal of different criteria that leads Eisinger to call muni insurance a racket is so well known that its not a scandal at all.
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